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My inner contrarian investor gets nervous when I begin to see such optimism about investment markets, and I’ve certainly noticed a positive change in investor sentiment lately. A year ago in early 2013, clients and prospects were still voicing a lot of concern. You might recall that the fiscal cliff, sequestration, tax hikes, etc. dominated the media. That seems to have mostly faded from investors’ minds, and stock indexes are powering to record highs as I write.

I’ve been relentlessly optimistic on stocks for the last five years, and I remain so for longer-term goals. But given the recent highs and improving sentiment, I’m feeling the need to calm client expectations for 2014. I will, however, lay out both sides on how stocks might perform this year.

My job is to keep clients focused on their longer-term goals and away from the latest noise in the news. As always, consume the caterwauling media at your own risk. But we’ll talk 2014 because it might be best to temper expectations going forward. We haven’t seen euphoria in a long time, and we’re not likely collectively there, yet. But given the tremendous rise in equity values since March of 2009, it’s important to remember that euphoria can destroy an investment strategy as easily as fear.

I don’t believe U.S. stocks in general are overvalued. Looking at historical metrics, they appear fairly valued: earnings are strong; inflation is low; there doesn’t seem to be any “irrational exuberance” in most markets; the U.S. is becoming a major force in energy production1; the emerging middle-class mega-trend continues; U.S. government debt is coming down (as a percentage of GDP); and gridlock in Washington is restraining the government from trying anything too stupid — well, mostly anyway.

International stocks actually look cheap in ways. Emerging market stocks lagged all year, and it appears that opportunities for bargains are emerging in Europe.

Many investors argue that quantitative easing (QE) is driving the U.S. stock market and that stock prices are artificially inflated. Perhaps to a degree, but stop and break that argument down. First, most of the QE money is not making its way into the economy. It’s hard to push a string, and most of the QE funds still sit on bank balance sheets as reserves (in other words, it’s not being loaned). Second, it’s primarily earnings and dividends that drive stock prices, and these numbers look solid. Third, companies have become very lean and cost-conscious,
and are sitting on a tremendous amount of cash. Companies could be well-positioned to take advantage of near-term opportunities.
The concern going forward is that a large percentage of earnings growth is still coming from cost-cutting, stock buybacks, and low interest rates. QE has helped large companies refinance debt to lower rates. And it is here that QE has helped publicly traded companies. How will the “taper” affect things? QE is truly unprecedented, and nobody — I repeat, nobody — knows for sure how the Fed withdrawal from QE will play out.

I believe QE has done its job — and QE could now be harming the economy by distorting markets and restraining banks from lending. Remember that interest rates are simply the price of money over time periods, and the Federal Reserve is distorting the price of money by forcing this price lower. Negative, real interest rates (“real” meaning after inflation) have traditionally caused inflation and misallocated capital to projects and investments that otherwise would not get presently funded. Many economists believe that this
“malinvestment” ultimately results in a lower U.S. standard of living. Low interest rates and over-regulation of banks are causing tighter lending standards than we would normally see in a recovery — thereby perpetuating a stubborn, though improving, unemployment problem.

I have argued that long-term interest rates probably need to increase more before banks are properly incentivized to lend money to small businesses, which are the primary job creators in the economy. (A huge segment of the homeowner population with good, but not spectacular, credit could also benefit from this.) Small businesses must rely on bank financing because they do not have access to capital markets2. The following is an example of how government pricing might distort markets.

What if the government, pursuant to some larger, benevolent public policy goal, ordered dairy farmers to lower the price of milk to 50 cents per gallon? How would dairy farmers respond? Considering the costs of production and running a business, I imagine they would stop producing milk and look to other farming activities for income. Less milk would be available, and perhaps more meat would show up in grocery stores — all distortions caused by the government pricing of milk. Banks are responding in similar fashion.

About the Author

Todd Kirsch is the owner and founder of Kirsch Wealth Management. He has been offering investments to the public since 1993. Prior to that time, he practiced law for a large, international law firm in the areas of tax, securities and corporations. He earned his law degree from Boston University a... More